The New Robber Barons Read online

  The rating agencies underestimated default probabilities, underestimated loss given default, and overly relied on historical data when assigning ratings. In a repeat of past mistakes, the basis of the analysis was flawed, and the amount of protection required to award the various ratings was insufficient at the outset.

  Solution: This requires a multi-part solution. Rating agencies may need an upgrade in the caliber of the people they hire, particularly since they’ve gotten probability of default and loss given default incorrect even on a granular basis (Enron and other granular risks). The Dodd-Frank Act calls for more transparency of the data and the criteria used by the rating agencies. That is a good idea, but as stated before, there should be third-party criteria for the benchmarks (the cutoffs) and the rating scale that corresponds to those benchmarks. A further step is to redirect the focus of the rating agencies from correlation to probability of default and loss given default.

  E. Rating Accuracy Should Be the Only Measurement of Success

  Neither the Dodd-Frank Act nor the European regulators clearly address the problem of conflicts of interest within the rating agencies. Dodd-Frank asks for two independent members in the administrative and supervisory board whose compensation isn’t linked to rating agencies’ results, presumably revenue targets. Agencies should focus on ratings issuance and not simultaneously provide advisory or consultancy services. The rules nebulously call for employees with knowledge and experience. The rules also call for staff turnover to avoid employees getting too close to entities they rate.

  The problem with this approach is the rating agencies will claim they already do all of the above. They will insist their people have the correct knowledge and experience. The key problem, however, is that business managers with revenue and market share targets sacrificed ratings accuracy. There were no consequences for this behavior. The rating “agencies” are companies, and shareholders like to see revenue growth.

  The awarding of so much power to the rating agencies created a welfare state of ongoing fees. Even today, there is rating shopping for products like Re-Remics. This indicates how ineffective the regulators have been and how ineffective the proposed rules will be in future.

  It’s time to make the goal and the measurement clear. The rating agencies are private companies owned by shareholders and management will therefore always push for ways to increase revenue in order to get higher compensation. Regulators can counter this by insisting on only one measurement of success. Rating accuracy can be the only measurement of success.

  Using rating accuracy as a measurement of success, Moody’s, S&P, and Fitch, the top three rating agencies, have all been failures. The NRSRO designation is completely unwarranted, and this is why I’ve revoked it. Beyond that, regulators should consider disqualifying rating companies from issuing any ratings whatsoever if there is a repeat of past “mistakes.”

  Solution: The consequence of making rating accuracy the only metric of success is that rating agencies/companies will have an incentive to purge management and withhold bonus compensation from managers that are not capable of producing accurate ratings for fear of losing the right to issue any ratings at all.

  Regulators can rate the rating agencies on the basis of accuracy and put companies on probation, meaning the companies can lose the right to issue any ratings. Whether or not regulators choose to take this step, the NRSRO doesn’t apply to any of the existing rating agencies, and in order to win that designation—which is above and beyond the previously mentioned ability to issue ratings—the rating agencies must demonstrate that they have completely overhauled methods and can produce accurate ratings.

  F. Conflicts of Interest: Chinese Wall Is Needed

  Within the rating agencies, analysts often report to business managers interested in building market share and revenues whether or not it comes at the expense of ratings accuracy. There is no “Chinese Wall” to protect ratings analysts from business managers whose bonuses depend on increasing revenues and market share.

  Solution: Since the rating agencies are private companies, they can choose their own system of compensation. Maximizing revenues at the expense of rating accuracy is contrary to public interest. Raters should be shielded from marketing managers and corporate management, and their compensation should be based solely on rating accuracy. See also the solution for Section E.

  G. Conflicts of Interest: Joint Ventures

  Rating agencies market risk consulting and models to banks and investors. At times, rating agencies have engaged in joint ventures with banks. For example, S&P entered into a joint venture with Bank of America Securities in the spring of 2003 to market Bank of America’s Lighthouse model. Bank of America Securities and S&P used the model to determine credit option adjusted spreads (OAS) and ratings analysis for credit portfolios. BAS’s senior manager wrote an email to his staff lauding the benefits of the joint venture with S&P: “This could be a significant development for us and give us entre into a lot of accounts in both Europe and US that we might not have by coordinating with S&P… If we handle this the right way, it could be a powerful tool, especially to clients below our radar screen or outside our reach internationally that S&P might have influence over.” BAS described a very cozy—and potentially very lucrative—relationship.

  Solution: The Dodd-Frank Act and the European regulators recognize this as a problem and recommend this type of consulting should not be simultaneous with ratings issuance, but they don’t go far enough. This sort of consulting business should be spun off. The stakes are so high for the rating “agencies” that if rating companies want to participate as raters in the global financial markets, they should have a single focus.

  H. Conflicts of Interest: Banks and Rated Entities Hiring Raters’ Employees

  Banks often hire rating agency analysts for their connections and influence within the agencies. There have been cases in which analysts hopeful of employment at a bank rated that bank’s securitizations created and sold for a given issuer/sponsor and later worked on securitizations of the same issuer/sponsor once employed by the bank. This poses another type of conflict of interest for the rating agencies. Analysts are tempted to be accommodating. (See Section IV. for the Commercial Financial Services’s example.)

  Solution: The Dodd-Frank Act asks for not-yet-created rules to adopt an employee look-back so that rating agencies can review ratings when an employee seeks or obtains employment with an entity that is subject to a credit rating. This is a good idea. A better idea is to ask if the incentives within the rating agencies and the lure of potentially lucrative jobs outside rating agencies resulted in collusion between rating agencies and banks to egregiously misrate securities at the outset, since that was the ratings result. The tough question was avoided in favor of a not-yet-defined rule. Another part of this solution should be to prohibit employees for accepting such employment for a period of two years, especially since remaining rating agency employees that engage in the look-back review are still subject to the same conflicts of interest that inspired the look-back review.

  I. Mistaken Idea: Rating Agencies Design Securities

  For all of their mistakes, the rating agencies have been unfairly characterized as having been the architect or co-architect of asset backed securitizations. While it is true that rating agencies were often over-accommodating to underwriters, they don’t design transactions by giving excessive guidance to bankers. Any project that requires approvals will have give-and-take in order to see the task to completion. The contribution of the dialogue between rating agencies and bankers to our current crisis has been blown out of proportion. That may serve the interests of banks that want to deflect attention from their failures in their duties as underwriters—not to mention their failure to comply with securities laws—but it does not help to define or solve the real problems.

  Solution: See Section E.

  J. A Mistaken Idea On Fees, and the Real Fee Issue

  Bankers raise capital by selling the bonds and equity
investments that result from a securitization of assets. A small portion of the capital is earmarked to pay the law firms, rating agencies, accountants, administrators, trustees, banks’ structured finance professionals, banks’ salespeople and traders, and so on. The idea that bankers pay rating agencies a rating fee thus creating a conflict of interest is a mistaken area of focus. In fact, proceeds from the investors from whom the capital is raised are paying the rating agencies’ fees. If investors in a deal agree they want an unrated deal, they can forego the rating altogether, albeit that is not practical for institutional investors whose charters or regulators require rated products. If one wants to use the argument that receiving pay from proceeds creates a conflict of interest, then one must apply it to the lawyers, accountants and any other professional not directly employed by the underwriter.

  While it is a concern, this issue has been blown way out of proportion. It would be more accurate to say that in the pressure to gain market share and increase revenues, rating agencies deliberately lowered standards to win business any way they could. This would likely have been a problem even if investors paid them directly.

  Solution: Both the Dodd-Frank Act and the European Regulators got the solution even when they didn’t correctly define the problem. Most of the rating agencies’ fees from a securitization are paid as a large upfront fee with a small ongoing maintenance fee until the securitization either unwinds or matures. If rating agencies’ fees are paid over time, their interests would be better aligned with investors.

  The rules should go a step further. It would also be a pious idea to make fees contingent upon the accuracy of the ratings for investment grade rated notes. One could achieve this by subordinating rating agencies’ realigned ongoing fee payments to the payments to the investment grade rated note investors.

  The further issue is the compensation of the management of the rating agencies. Again, making ratings accuracy the only measurement of success (from a regulatory point of view) and ranking and disqualifying rating agencies from being eligible to issue ratings whatsoever would be an effective incentive to realign priorities within the rating agencies. Irrespective of the previous comments, I revoke the NRSRO designation—which is separate from the ability to issue ratings—of all the rating agencies.

  K. Ban Credit Derivatives and Total Return Swaps in Rated Structured Financial Products

  Neither the Dodd-Frank Act nor European regulators tackle this issue head on. Credit derivatives technology was used to reference the worst credits more than once in more than one securitization. Total return swaps were also employed in some CDOs. All of these transactions are over-the-counter (OTC) meaning these derivatives are not transparent and do not trade on exchanges. Buried within the documentation are numerous ways to stuff hidden risks into the portfolio. This discussion is beyond the scope of this report, but rating agencies have proved themselves inadequate to the task of unpacking these risks and putting a sensible rating on securitizations that include these risks.

  In fact, many “experts” in credit derivatives have been caught off guard by hidden risks. There have been many private disputes about the meaning of the language in over-the-counter documentation. Making the documents public on a web site may provide more disclosure, but that isn’t the same thing as transparency.

  Solution: Ban the use of credit derivatives and total return swaps in rated structured finance transactions.

  L. Other Derivatives in Rated Structured Financial Products

  Neither the Dodd-Frank Act nor European regulators deal with raters’ ability to cope with derivatives. Based on my past interaction with the rating agencies, they do not have sufficient competence in foreign exchange derivatives (and quantoed deals), commodity derivatives, or interest rate derivatives to award credit ratings to deals that include the risk presented by the derivatives, even when the derivatives are labeled as “hedges.”

  Solution: See Section E.

  M. “Managed” Deals

  Neither the Dodd-Frank Act nor European regulators address this. In the CDO debacle, most of the deals were “managed.” There is evidence that deal managers had a variety of unacceptable issues including but not limited to 1) shady backgrounds that were discoverable in the course of normal due diligence, 2) close ties with banks that underwrote deals and a dependence on those banks for fee revenue, 3) conflicts of interest with CDO investors and other funds managed by the “manager.” Some of these managers were fly-by-night operations that went bankrupt or are now effectively without any business.

  Partial Solution: Background checks are a partial solution, but the reality is that when a manager has a conflict of interest with the CDO investor, it has never turned out well for investors, and ratings have proved meaningless. There are ways of putting “handcuffs” on managers by writing trading rules into the documents, yet even these rules can be thwarted.

  N. An Observation: “Agencies” are Companies; Shareholders Cannot Govern Rating Agencies

  Neither the Dodd-Frank Act nor European regulators address this. The rating agencies are shareholder owned entities and are in the unusual position of having enormous power, which they’ve perverted and abused. They can at will change the definition and methodology for their ratings and thus the capital reserved by several financial entities. By getting the ratings so risibly wrong on investment grade products, they’ve enabled a global financial meltdown.

  Warren Buffett, CEO of Berkshire Hathaway, has sometimes said that shareholders must demand changes to limit compensation and excesses of company officers, but he himself did no such thing when it came to Berkshire Hathaway’s investment in Moody’s, at least while it raked in fees from rating structured products. At the end of 2007, after the issuance of misrated private label securitization had ground to a halt, Berkshire Hathaway still owned 48 million shares of Moody’s Corporation, the same number of shares Berkshire Hathaway owned in 2005. The shares represented just over 19 percent of Moody’s capital stock. To the best of my knowledge, at no time did Buffett interfere or attempt to positively influence the behavior of the rating agencies when it came to the misrated financial products that damaged the financial system. Yet at the time, Buffett was not completely unaware of the problem.

  It’s ironic that Buffett makes no secret of the fact that he himself disregards ratings when making investment decisions. He is concerned with the ratings of Berkshire Hathaway only to the extent that other investors rely on them. Ratings affect Berkshire Hathaway’s cost of borrowing and its ability to attract insurance premiums. Buffett has recently been selling off blocks of his shares of Moody’s.

  The role of the rating agencies has been so pervasive and influential that it cannot be left up to “efficient market” forces—proven to be inefficient and distorted through crony capitalism—or to shareholders to correct problems.

  Solution: Regulators cannot make shareholders do anything, but they can change the incentives. (See Section E.)

  O. Thwarting Dodd-Frank: Risk Retention and “Conflict of Interest” Transactions

  The Dodd-Frank Act provided a reason for me to laugh out loud at a couple of sections. First, it is useful to point out that had existing securities laws been enforced, the “added” prohibitions in the Dodd-Frank Act wouldn’t be necessary. Yet regulators and Congress abdicated. The clock on the Statute of Limitations is running out for enforcement (five years for securities fraud). Denial of widespread malfeasance and fraud leads to the type of ineffective legislation evident in the Dodd-Frank Act.

  In an attempt to say “We Fixed It!” the Act proposes stern sounding prohibitions that any competent structured finance professional can thwart. The first is the idea of risk retention. Congress may recall Goldman’s CEO, Lloyd Blankfein, claiming that Goldman retained the ‘first loss” risk of CDOs. I can think of several ways in which Blankfein can make that statement with a straight face, while Goldman may have had virtually no risk whatsoever.

  Dodd-Frank asks for at least 5% risk retention and
the position must be unhedged. In addition, the waterfall of the cash flows must be made available. I can think of several ways to thwart this rule’s intention. Here’s just one way that doesn’t even involve derivatives. As I explained in my 2003 book, one can create a CDO in which the “first loss” risk is actually safer than the “AAA” tranche of the CDO since cash flows are diverted to the “first loss” risk holder in a hidden way. I defy regulators to read the deal documentation and figure it out. So much for Dodd-Frank’s “risk retention.”

  Moreover, it pays to state the blindingly obvious. The Act is relying on clever people who thwarted existing disclosure requirements, and who remain unpunished, to now follow the disclosure requirements of the Act. Good luck with that.

  Solution: The goal is to prevent corrupt underwriters from selling junk as “investment grade,” and from selling junk as “AAA.” The global financial community has chosen to hide under their desks rather than confront this issue. Given this reality, it may be more effective to insist that “AAA” meets third-party global benchmarks and has a global meaning. If rating agencies cannot produce ratings that live up to that meaning, they should no longer be allowed to issue ratings.